On the Ground in China: Observations from the Middle Kingdom

In our recent two-week tour around China, the essence of the new Chinese Communist Party administration’s policy intentions became increasingly clear to us. Political legitimacy and stability remain the twin goals of the Party/State.

However, the policies being embraced to achieve these goals have begun a watershed shift, which should impact how investors think about China in the years to come.

Slower, but More Sustainable Growth

Over the past three decades, growth-at-any-cost has been the paramount goal. In the coming decades, in our view, the focus will be on sustainability, fairness (social mobility), and productivity improvements. Quality growth along with economic reform will be used as policy instruments to achieve these objectives.

Increased Social Mobility and Policies to Promote Equity and Fairness

There is a decided shift toward greater fairness and equity across society. After decades of unrestrained – and occasionally reckless – growth, policy has now begun to emphasize social mobility through urbanization, housing and land reform, and efforts to improve outcomes for the 50% of Chinese still living in rural areas. We are also witnessing improvements and experiments in healthcare delivery, economics, and insurance. The enormous popular support for Xi Jinping rests on perceptions that the decades of illegitimate wealth, party corruption, and increases in inequality are finally being addressed.

In parallel, there appears to be a determined effort to improve provincial and municipal governance. There is heightened discussion about fiscal reform to enhance the capacity of local governments to fund their growing social burdens (education, healthcare, pensions). We have long believed that redistribution designed to improve social mobility would have a pronounced impact on sustainable growth given a higher propensity of the urban poor to consume.

Improvements in Environmental Sustainability

A renewed focus has also been placed on environmental sustainability. This was evident this winter in Beijing, where we experienced a week of the least smoggy skies we have witnessed in years. This environment change was the result of substantial reductions in manufacturing and thermal coal capacity. We continue to believe these reductions underpin the prospects for sustainably rich earnings for mining companies.

Supply discipline helps Beijing achieve the twin goals of environmental improvements and stronger cash flow capacity in the commodity sector – an important source of credit risk in the financial sector. We firmly believe that supply discipline in China, coupled with investors’ continued nausea following a decade of extraordinary metal price volatility, will underpin strong cash flows and dividends (which investors demand) for companies such as Glencore, Vale, and Anglo American.

Orderly Corporate Deleveraging

We are also seeing a determined focus on financial stability and orderly corporate deleveraging. We continue to disbelieve naysayers’ calls for an inevitable “credit event,” following the tremendous increase in corporate leverage over the past decade. There appears to be coherence now about the importance of deleveraging – a focus evidenced by the new financial stability committee, which has been created and tasked with orderly corporate deleveraging. There has been a massive regulatory crackdown on unhealthy “wealth management” products (yawning asset-liability duration mismatches, unsustainable yield guarantees, etc.) and a determination to bring credit from the shadows into the capital markets or back onto bank balance sheets.

Focus on Profitability and Governance in State-Owned Enterprises

Corporate profitability and governance are also a key focus for state-owned enterprises (SOEs). While privatization seems unapproachable, there is a strong focus on building stronger, more profitable SOEs. There have been a handful of very large industrial mergers designed to improve market structures, profitability, and cash flow to invest in growth. It is clear that a wave of industrial restructuring could occur over the next few years, which could create very interesting investment opportunities.

Other trends that bear watching include:

Declining levels of investment, but higher returns on investment as the private sector continues gaining share and as restructuring improves market structures and profitability in the state sector.

Heightened innovation and powerful technology transformation across traditional verticals including retail, logistics, finance, and transportation. China has overtaken the United States in the speed of transformation in e-commerce, Internet advertising, and content, and it will do the same in many new industries largely because it has fewer entrenched and competitive alternatives. Additionally, China has tremendous human capital and, because of increased opportunity there, the country has become a magnet in recent years for the Chinese diaspora across the world to return.

The emergence of globally competitive Chinese companies, particularly in technology. We believe Alibaba, Didi, CTRP, and Tencent will surprise investors with meaningful acquisitions, partnerships, and expansions throughout the developing world over the next few years.

Ultimately, Emerging Markets Are All About China

The environment today continues to reinforce our long-held view that, at their core, emerging markets are all about China. This goes beyond just the scale of the factual data, though we should bear witness to some of those facts:

JP Morgan estimates that China will contribute roughly 33% to global GDP growth between 2017 and 2019. In the emerging market (EM) world, China’s growth contribution will be 57% over the same time period.

China’s stock market capitalization is second only to the United States at roughly $12 trillion, having grown from just $0.7 trillion in 2003.

China represents 29.7% of the MSCI EM Index, which has yet to account for the impact of China’s A-share market. In August 2018, A-shares will begin to be phased into the index. It is estimated that, upon full inclusion, China could represent up to 37.2% of the index.

Perhaps more significant than the data above is the increasing dependence of emerging markets on China. The mainland’s relevance in resource consumption globally has been well documented, though it is unlikely that many investors fully appreciate its significance – 13% of Russia’s oil, 28% of Brazil’s iron ore, 33% of Indonesia’s thermal coal, and 40% of Chile/Peru’s copper all go to China. Further, as China extends its newfound discipline in the resource space – electing for environmental awareness over exploitation of its own (often sub-par) reserves – this discipline feeds into the narrative of greater stability in resource prices, underscoring some of our sector investments outside China (Glencore, Vale, etc.).

China’s role as a trading partner puts it in a unique position. Indeed, it is the largest trading nation in the world, at $3.96 trillion in net trade activity in 2015. That year, 101 countries and regions had more trade with China than the United States, while 43 (mostly developed countries) had less. In 2014, China accounted for 48% of Taiwan’s exports, 34% of the Philippines’, 33% of South Korea’s, 49% of South Africa’s, 28% of Chile’s, and 24% of Malaysia’s.1

What does this mean for our approach to EM investing over the next few years? While we will continue to embrace our bottom-up approach of seeking out the best companies in the world, it is increasingly clear that an in-depth and thorough understanding of China’s current and future macroeconomic picture, political imperatives, and impact on the broader EM universe is necessary to continue the success we have enjoyed to date.

The Unstoppable Rise of China

The unstoppable rise of China has been one of two core themes in Oppenheimer Developing Markets Fund (ODMAX) in recent years (the other is Technology). A glance at our country weightings would indicate that, as of December 31, 2017, 23.9% of our holdings are in China versus the benchmark’s weight of 29.7%. However, this weighting belies our true exposure to China, as expressed through investments oriented to China demand. These include our luxury investments, including Kering (2.4%), LVMH (1.6%), and Prada (1.1%); as well as our cosmetic exposure in Korea (LG H&H and AmorePacific, for a combined 2.4%). Through Hong Kong, our holdings in AIA (2.9%) and HKEX (0.5%) are plays on financial and capital market liberalization on the mainland. Adding these would take our China exposure to 31.9% – and we are on the hunt for more. Even our mining exposure (Glencore, Grupo Mexico, Anglo American) are names that ultimately are driven by cyclical vacillations in the unstoppable growth story that is China.

Of course, our history demonstrates that we are, in fact, benchmark agnostic. Recall that we had more than 1,000 basis points of our holdings in American Depositary Receipts (ADRs) before benchmark changes began to incorporate them. At the end of the day, our approach to China is the same one we apply with all of our investments: We seek exceptional companies with durable, long-tailed growth and optionality, and which have significant and sustainable advantages. We avoid capital-intensive and highly cyclical companies with little competitive differentiation (these include the finance-heavy MSCI China and A-share markets). And generally speaking, we are not enamored with the idea of SOEs, most of which inherently carry the baggage of inefficient balance sheets, bloated employee rosters, and moral suasion.

That said, we are not blind to a lot of fertile ground in the A-share and private markets in China. Gravitational forces will likely redefine the compositional make up of Chinese names in the index, alongside the growth-driven increased weight of the country. We have found some excellent opportunities in the A-share market, like Jiangsu Hengrui (pharmaceuticals) and Kweichow Moutai (the world’s most valuable spirits company); as well as in private companies that will soon go public (Didi, the world’s largest ride-hailing company). We believe we remain at a relatively early stage of the globally transformative story that China represents.

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